Saturday, November 6, 2010

More on QE2

After the Fed statement on Wednesday, which I discussed here, we have plenty of opinions on what the Fed is up to. Martin Feldstein (actually from the day before the statement, but presumably his opinion did not change with the actual announcement) thinks it's risky, and some of the business press is negative, particularly this guy, who claims Bernanke doesn't know any economics, but apparently his grasp is not the best either. Predictably, Krugman and this two buddies DeLong and Thoma think the asset purchase program should have been larger. DeLong has a particular complaint about the average duration of the the Treasury purchases. Now, in the interest of encouraging people when they say something useful, the guy actually has a point here. The New York Fed page where the relevant information resides is down for maintenance today, but you can find the details of what the Fed plans to purchase here. Very little of these purchases will be of Treasuries with maturities greater than 10 years, and the average duration of purchases will be 5-6 years. On the up side, there is then less maturity mismatch on the Fed's balance sheet (which of course is risky for them), but if QE works in the fashion the Fed hopes it will, then longer-maturity asset purchases would give the Fed much more leverage.

Bernanke felt the need to market QE2 to the public in this Washington Post piece. The basic argument for QE2 we have heard before, which is that the unemployment rate is stubbornly high, and the inflation rate is lower than the Fed would like. Further, Bernanke has some fear of deflation too:

In the most extreme case, very low inflation can morph into deflation (falling prices and wages), which can contribute to long periods of economic stagnation.

So, apparently he is with Jim Bullard in viewing a deflationary state as potentially absorbing and harmful to real activity.

Although asset purchases are relatively unfamiliar as a tool of monetary policy, some concerns about this approach are overstated. Critics have, for example, worried that it will lead to excessive increases in the money supply and ultimately to significant increases in inflation.

Our earlier use of this policy approach had little effect on the amount of currency in circulation or on other broad measures of the money supply, such as bank deposits. Nor did it result in higher inflation. We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time. The Fed is committed to both parts of its dual mandate and will take all measures necessary to keep inflation low and stable.

Note here that Bernanke is actually paying attention to some monetary quantities, in particular the stock of currency and bank deposits, which is unusual.

Now, I think it is quite possible that we will look back on QE2 as a severe error. In spite of the talk from some quarters about the intervention being too small, this is a very large-scale asset purchase for the Fed, on top of a previous very large purchase of mortgage-backed securities and agency securities. One possibility is that economic growth picks up, of its own accord, reserves become less attractive for the banks, and inflation builds up a head of steam. The Fed may find this difficult to control, or may be unwilling to do so. Even worse is the case where growth remains sluggish, but inflation well in excess of 2% starts to rear its ugly head anyway. Bernanke is telling us that he "has the tools to unwind these policies," but if the inflation rate is at 6% and the unemployment rate is still close to 10%, he will not have the stomach to fight the inflation.

My concern here is that, given the specifics of the QE2 policy that was announced, the FOMC will be reluctant to cut back or stop the asset purchases, even if things start looking bad on the inflation front. Once inflation gets going, we know it is painful to stop it, and we don't need another problem to deal with.

Inflation wasn't nearly as painful and costly to stop in the early 80s as two lost decades for Japan, and that was stopping some very high inflation, close to 15%. It would be hard to believe that with the Fed's behavior over the last generation, they wouldn't act well before inflation got that bad, making the adjustment far more gradual and less painful. And by all accounts it's much easier to gradually reign in moderate inflation than to stop deflation and stimulate an economy at the ZLB.

The risk of too little inflation, too little stimulation, seems far greater than the risk of too much. It's like not taking even a moderate dose of penicillin when you have severe pneumonia. The risk of taking too little is far greater than the risk of taking too much, when you're talking about just a moderate, or very small, amount.

You could say look at 70s stagflation. But that was largely due to a one time oil shock, a temporary thing. Oil prices can't increase at rates anywhere near that high forever, or soon no one will be able to afford to use oil; we'll be forced to switch to nuclear with electric cars and mass transit, liquid coal, something else.

And partly it was also due to starting with very high inflation and then the Fed engineering a recession to bring it down -- the recession comes first, so for a while you have still pretty high inflation and a recession as the recession grinds the inflation down. But now we're starting with close to deflation and a severe recession (in unemployment).

Yes, Backus and Kehoe's paper is one among a class that delivers irrelevance results. Another is Neil Wallace's 1981 AER paper, which establishes conditions under which open market operations are irrelevant. So, the Fed swaps interest-bearing reserves for long-maturity Treasuries. Why does this matter? In a world with complete markets, as in Backus and Kehoe, of course it can't matter. The private sector will just undo this. However, we don't live in a world with complete markets. The question then is: what are the frictions in the world that could make QE2 matter, and matter significantly? Then, we want to know whether this intervention somehow makes us better off. Unfortunately, there is not good theory out there, or sufficient empirical evidence, to tell us much about what to expect. People at the Fed seem to have some kind of vague portfolio balance theory in mind (of the kind Backus and Kehoe were criticizing), or a segmented markets/preferred habit story about why changing the maturity of the government debt matters. I think this potentially has inflationary consequences that we won't like, as discussed above.

Let me jump into your conversation with Richard. The only way to get from our present situation to 6% inflation and 10% unemployment would be one where there are negative aggregate supply shocks. A positive aggregate demand shock, on the other hand, would push up inflation and (given sticky wages, prices, and resource slack)the real economy.

One can argue that the Fed is not being systematic about its actions or following some kind rule-like reaction function (which can create its own problems), but the basic idea behind QE2 is straight from the AD-AS model.

1. I'm just pulling numbers out of nowhere when I'm talking about 6% inflation and 10% unemployment. The key point is that it is quite possible that the real effects of QE2 are negligible and but the nominal effects are not.

2. I'm sorry that the AD-AS model is all you have to work with, but I can assure you that the architects of QE2 actually had some better tools at their disposal. If you took that thing into an FOMC meeting, you would get a few chuckles.

Could you expand on #2? Do you mean by "better", a more detailed and operationally relevant tools? I can buy that, but even so the intuition behind how they ultimately play out is still based on a AD-AS model. I have read the transcripts from some FOMC minutes and though there are technical discussions, ultimately the insights are often couched in terms of an AD-AS model. So what exactly do you mean?

"ultimately insights are couched in AD-AS terms" says anonymous at 8.57.As I recall, Marvin Goodfriend (or it could have been Robert King) said in a Fed article a few years back that macro insights could always be expressed in terms of IS/LM/AD/AS for a lay audience, but the model was useless for deriving theoretical results. So AD/AS is like a picture in a physical chem book showing the atom as a "sun and planet" setup but we know that to understand the atom you have to use a far more sophisticated theory. But sure, IS/LM/AD/AS is great for the principles of macro student.

So let me get this straight, Stephen Williams points out his concerns about QE2 (such as the impact of bank reserves in the futre) without specifying a full theoretical model to justify his concerns. He just assumes his concerns and that every one understands them. Yet, this is exactly what the anonymous above is doing when referencing the standard macro workhorse IS-LM-AS model. Yes, one could explain its microfoundations more thoroughly but most economist (including Fed officials) do not and use the model in taliking about policy. For example, Bernanke in his famous 2002 speech talks about deflation be the result of a collapse in aggregate demand.

It pains me to do this, but here goes. The AD/AS I remember comes in two forms. In one the price level is fixed (horizontal AS) and in the other the nominal wage is fixed (upward sloping AS). How does monetary policy work in that model? In the usual case, M goes up, AD shifts right, you get higher P and higher Y. In the liquidity trap case the LM curve is flat, the AD curve is vertical, and moving M around does nothing. So either we're not in the liquidity trap case, so we increase M, r goes down, Y goes up and P goes up, or we're not in the liquidity trap case and M goes up but nothing happens. But M just went up by a whole lot and nothing happened, so we must be in the liqudity trap case (and of course we know the nominal rate is close to zero. Therefore essentially nothing will happen. So why are we doing QE2?

Here's what the Fed people are actually thinking about. They are thinking there is a liquidity trap in that, if they buy more T-bills, nothing will happen. However, they think that if they buy long-maturity Treasury bonds, they can actually reduce long bond yields, and can also potentially demonstrate a commitment to higher inflation, and manipulate expectations about future inflation. These are all dynamic issues. We need a dynamic model to think about debt of different maturities, and we need a more sophisticated way of thinking about government financing and central banking than what is in that AS-AD framework. Using AS-AD to think about this problem is like using a saw to take out an appendix. Forget it. It's a piece of crap.

First anonymous:

Yes, good point. For example in Wallace's '81 AER paper, markets are certainly not complete. He's actually got an OG role for money in there, and in spite of that the open market operation has no effect on anything, including the price level.

"The question then is: what are the frictions in the world that could make QE2 matter, and matter significantly?"

When the Fed bought up Agency MBS in 2009 it picked up about 25% of the outstanding float. With QE2 ($600b purchases, about $7T longer term debt outstanding) it is picking up less than 10% of the float.

The larger the buyer & the smaller the market the more will prices be pushed as a buy order is executed. So relatively speaking the Fed can skew prices much more in agency MBS markets than the broader Treasury markets.

A smart buyer tries to hide and slowly accumulate so as not to buy at inflated prices. Naive buyers who announce purchases ahead of time will pay inflated prices.

Operating in small markets and pre-announcing is the best way to overpay for assets, thereby reducing your financial strength, and thus diminishing the value of your liabilities.

So I'd say that QE2 will probably reduce the value of the dollar, a liability of the Fed, but not as much as the agency purchases reduced the dollar. They will overpay to a lesser degree.

The friction, or departure from perfect markets, is that large actors like the Fed are not price takers but can impact prices.

I don't think anyone is saying to literally use the simple AD-AS model that abstracts from the complexities that you bring up. But, all the consequences of QE2 you mention--lowering long-term interest rates and changing inflation expectations--are important to the extent they alter aggregate spending or AD. Yes, there are many dynamic issues to consider, but the end effect can be nicely summarized in terms of the AD-AS model.

I'm not sure what you mean by "float." My understanding is that, when the Fed was purchasing MBS, it was essentially the only buyer of newly-issued securities in that market, so we could say that they effectively set prices for MBS. However, MBS is just part of the market for long-term debt, and I can't see that the Fed's ability to move asset prices in general is any different if they purchase MBS than if they purchase long Treasuries.

Anonymous:

As I said, I learned all that stuff at some point, and I learned a lot of modern macro too. Once I understood the latter, there seemed to be no point in thinking about AD-AS. It's very misleading. You can't really think of it as summarizing what's in serious model.

Thanks. I thought that there was a period, when the Fed was in its MBS purchase phase, where most of the new mortgage debt in the US was being purchased by Fannie Mae and Freddie Mac, and subsequently ended up on the balance sheet of the Fed, either in the form of MBS created by Fannie and Freddie, or as agency debt of Fannie and Freddie.

"Thanks. I thought that there was a period, when the Fed was in its MBS purchase phase, where most of the new mortgage debt in the US was being purchased by Fannie Mae and Freddie Mac, and subsequently ended up on the balance sheet of the Fed, either in the form of MBS created by Fannie and Freddie, or as agency debt of Fannie and Freddie."

The Fed can't buy directly from the agencies. All newly issued agency MBS would have been bought by private actors (or governments like China), and then the Fed would have purchased said MBS from these private actors. Much of it probably did end on the Fed's balance sheet, but the Fed wasn't the only buyer. Its ability to set a floor would have depended on how aggressive it was and the size of its offers relative to competing buyers, I guess.